A Fed-blown bubble?

The Federal Reserve’s large-scale asset purchases, known as quantitative easing, are designed to put downward pressure on interest rates. A recent flurry of academic work has documented that the policy has indeed pushed interest rates lower for the types of assets, especially mortgage-backed securities and Treasuries, that the Fed has purchased.

A reduction in interest rates could drive investors to substitute other assets for bonds, and some observers have begun to wonder whether the recent rises in equity markets might be signs that the Fed is inflating a stock-market bubble. Former Fed chairman Alan Greenspan remarked recently that he expects a “significant correction” in the market, and even current Fed chairwoman Janet Yellen conceded that “valuation metrics in some sectors do appear substantially stretched.”

Is the U.S. stock market in a Fed-blown bubble? The accompanying chart explores the question. Specifically, it shows the three-month moving averages of the month-over-month percentage change in the Fed’s balance sheet, and the U.S. stock market’s outperformance of the stock markets of OECD countries that have not engaged in large-scale asset purchases (that is, we exclude the U.S., the U.K., and Japan). Even though the Federal Reserve first announced quantitative easing in November 2008, the chart begins in January 2009, the first month for which it is possible to calculate the three-month moving average.

Two things jump out of the chart. First, the U.S. stock market has outperformed relative to the OECD average during the time period represented, by about 0.4 percent per month. Over the entire time period, the U.S. market is up 98.8 percent, whereas the rest of the OECD is up 67.9 percent on average. Second, the U.S. has tended to outperform in the months in which there were bigger increases in the Fed balance sheet. Indeed, the correlation between the two lines is highly statistically significant.

A pessimist would look at that correlation and say it confirms that the Fed has inflated a bubble. A defender of the Fed’s action, however, might argue that quantitative easing has bolstered the economy, and that higher economic growth explains the booming U.S. stock market. Over this time period, the U.S. has grown about half a percentage point per year faster than the comparison set of countries, which provides some support for this view. Looking ahead, perhaps the most troubling thing in the chart is that the high correlation between Fed purchases and stock-market gains is not limited to a few announcement days. It appears that even fully anticipated Fed actions have continued to affect the markets. This might be because the market worried that the Fed might change its mind and stop early, but even so, it does suggest that the end of quantitative easing, which is likely in the fall, could mark the end of U.S. equity markets’ recent outperformance of the rest of the world.